Another Rescue? 2.7 Trillion USD Muni Bond Market Nagging for Federal Bailout

Discussion in 'Wall St. News' started by ByLoSellHi, May 29, 2009.

  1. Well, to the tune of 400 Billion of VRDOs, at any rate.


    Another Rescue?

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    Published: May 28, 2009

    Remember the days, not so long ago, when you had never heard of subprime mortgages or credit default swaps or collateralized debt obligations? As government officials try to sort out those messes, states and localities are asking for federal aid for another financial trouble child: the VRDO, or the variable rate demand obligation.

    A VRDO (rhymes with weirdo) is a type of municipal bond that combines a long maturity with a floating interest rate and other tricky features. With some $400 billion outstanding, VRDOs are a big chunk of the $2.7 trillion in municipal debt that has been issued by more than 50,000 entities, mainly state and local governments.

    As the recession has deepened, impairing the credit quality of insurers and banks that back the bonds, interest-rate increases have been triggered on some VRDOs. That has led to higher debt payments at a time when municipalities can least afford it. It has also become increasingly more expensive to issue new bonds, because fewer insurers and banks are able or willing to backstop them, especially for cash-strapped issuers.

    The result has been less access to capital at a higher cost, a squeeze that state and local governments say will only prolong the recession.

    On Capitol Hill, Representative Barney Frank, the chairman of the House Financial Services Committee, is now drafting legislation that would provide federal backing for VRDOs and other municipal bonds. That would make it easier and less costly for state and local governments to borrow.

    At first glance, support for the municipal bond market seems like one more unfortunate but unavoidable lifeline for a troubled financial system. But we are not yet persuaded that the need is as urgent as some politicians are claiming — or if such support would be wise.

    States and localities are hurting, no doubt. But they have also been on the receiving end of substantial federal stimulus dollars, and will likely receive more if the downturn deepens. They also will be the direct or indirect beneficiaries of other policy actions — like federal foreclosure relief and the bank bailouts. Encouraging more borrowing, especially with potentially dicey instruments, may not be the best way to help.

    There is a legitimate concern that propping up VRDOs could lead governments to over rely on them, even though the financial crisis has exposed their weaknesses. This latest round of trouble is also one more reminder of the urgent need to reform the credit rating agencies, whose faulty ratings led in part to the municipalities’ reliance on VRDOs and other borrowing.

    If federal backing is deemed necessary, Congress must be frank about the costs and risks. Debt guarantees by the Treasury can carry a cost, even if there is no immediate outlay. In the year a guarantee is extended, the federal budget records an amount that the government is likely to lose in the event of default. Each year the amount is re-estimated, based on the loan’s performance. Losses add to the budget deficit and the federal debt.

    That isn’t the only cost. The more the government spends, guarantees and borrows to prop up the financial system, the more nervous investors have become about the possibility of future inflation, a worry that of late has contributed to big swings in the stock market.

    In these very difficult times, states and localities certainly need help from the federal government. But before any support is provided to the municipal debt market, the case for aid has to be made based on thorough analysis and full transparency.